Last Updated on May 25, 2022 by Neera Bhardwaj

Hedge funds are actively managed alternative investments that use non-traditional asset classes or investment strategies. Hedge funds trade in fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodities options, and other non-securities assets in addition to stocks.

What are hedge funds?

Hedge funds are unregistered private investment joint ventures, funds, or pools that invest and trade across a broad variety of markets, techniques, and instruments. They are not subject to the same regulatory requirements as mutual funds, such as providing investors with certain standardized pricing and valuation information regularly. Furthermore, hedge funds employ a combination of strategies like hedging and arbitrage methods to achieve their goals of investment returns. Being high-value and high-risk investments, hedge funds generally target high net worth individuals and institutions for their clientele.

Valuation and management of hedge funds

A hedge fund invests money from approved investors including insurance companies, banks, wealthy families, as well as endowments and pension funds. These funds frequently operate as foreign investment corporations or private investment partnerships. They don’t have to register with SEBI (securities exchange board of India), and they don’t have to report their NAV (net asset value) regularly like mutual funds.

Asset types such as derivatives, stocks, bonds, currencies, and convertible securities make up a hedge fund’s portfolio. As a result, they are sometimes referred to as alternative investments. They require active management of the grouping of assets with the aim to ‘hedge’ risks to investor money against market ups and downs. Unlike other stocks or mutual funds, hedge funds tend to use a lot of leverage. They invest in both long and short positions, as well as listed and unlisted derivatives.

Characteristics of hedge funds

  • Hedge funds are structured as private investment partnerships or offshore investment corporations
  • They employ a wide range of trading strategies involving position-taking in a variety of markets
  • They may pay performance fees to their managers
  • They target rich individuals and institutional investors, and have a relatively high minimum investment limit

Who should invest in hedge funds?

Hedge funds are like mutual funds that are managed by professionals privately. As a result, they are usually a little more pricey. Because the management buys and sells assets at dizzying speeds to keep up with market changes, you must not only have extra cash but also be an aggressive risk-taker. 

As you may be aware, the more structural complexity there is, the greater the hazards. Therefore, hedge funds have a much higher expense ratio than regular mutual funds. First-time depositors may do well to stay away from these funds unless they have a sizable corpus and a risk appetite to match.

Types of hedge funds

Domestic hedge funds

Domestic hedge funds are only available to investors who are taxed in the nation of origin.

Offshore hedge funds

Offshore hedge funds are funds that are created outside of your home nation, preferably in a low-tax jurisdiction.

Funds of Funds

These are mutual funds that invest in other hedge funds beyond geographical borders, a type of mutual fund that pools money and employs two or more sub managers to invest it in stocks, commodities, or currencies. Investors allocate assets to FoFs for a variety of reasons, including diversity across managers’ styles and risk exposure.

Hedge funds can also be differentiated on the basis of their investing strategy such as event-driven funds invest in assets to profit from price fluctuations caused by business events. Merger arbitrage funds and distressed asset funds are included in this category.

Global macro funds

These are hedge funds that take long and short positions in major financial markets depending on economic trends and events.

Market-neutral funds

These are those in which the management tries to keep market risk to a minimum (or as low as possible). Long/short equity funds, convertible bond arbitrage funds, and fixed income arbitrage are all included in this category.

Trading philosophy

A hedge fund is a regulated investment fund that is generally only accessible to a select group of high value investors – high net worth individuals and firms. Every hedge fund has its investment philosophy, which influences the kind of investments made and techniques used. Hedge funds, in general, engage in a far broader variety of investing and trading activities than typical long-only investment funds (mutual funds, AMCs, etc.). Hedge funds engage in a diverse variety of assets, including long and short stock, bond, commodity, and derivative positions.

Risks and returns of hedge funds

The aforementioned facts about regulatory standards being relaxed say eloquently about the product’s high-risk level. Apart from the fact that the underlying securities in which top hedge funds invest are similarly high-risk, the product is not legally required to register with the SEBI or to disclose its NAV. These two elements ensure that the rest of the money is closely monitored and regulated. This does not imply that SEBI leaves this money unattended, but the lack of a legal obligation raises the risk threshold.

Risk and reward are exactly proportionate, as we all know. Hedge fund returns, like their risks, are on the upper end of the spectrum.

Benefits of investing in hedge funds

  • Investing in hedge funds has several advantages, including alignment of interests between investors and fund managers, flexibility, and an aggressive investment approach. Hedge funds are set up in such a manner that the fund manager’s and investors’ interests are aligned, including features such as a high watermark. The high watermark clause permits the fund manager to only be rewarded for his performance if the fund exceeds a particular threshold.
  • At the outset, hedge funds may help the financial markets by improving market efficiency and increasing liquidity. On behalf of their managed hedge funds, many hedge fund advisers take speculative trading positions based on thorough research into a security’s real worth or prospective value. 
  • Hedge funds utilize short-term trading methods to take advantage of perceived securities mispricing. Because securities markets are dynamic, market prices of securities will shift closer to their real worth as a result of such trade. 
  • Hedge fund trading can, therefore, supply pricing information to the securities markets, potentially resulting in market price efficiency. 
  • Hedge funds can assist companies in reducing or managing their risks by actively engaging in the secondary market for these instruments since a portion of the financial risk is moved to investors in the form of these tradable financial instruments. This market activity has the extra benefit of decreasing the financing costs borne by other sectors by reallocating financial risks. Hedge funds’ exclusion from these markets may result in fewer risk management options and a higher cost of capital.

Hedge funds are effectively implemented and managed alternative investments that use non-traditional asset classes or investment strategies. In the last 20 years, the number of hedge funds has increased dramatically in India. Hedge funds are more expensive than traditional investment funds, and they often only find interest among high-net-worth individuals or institutional investors. 

Ayushi Mishra